Chicago specifically and the Midwest more generally appear likely to see their share of commercial real estate distress as 2023 progresses, real estate attorney David M. Gottlieb told Connect CRE. “I think you can lump our area in with other regions as likely to take their lumps due to the fallout from COVID’s hybrid work schedules and rapid interest rate increases,” said Gottlieb, founder of GottsLaw LLC in Northfield, IL. 

With a three-decade career in law, finance and CRE sales spanning both the early-1990s S&L collapse and the 2008 Great Recession, Gottlieb said the office sector is the number one concern mentioned by bankers with whom he has spoken recently.

“COVID changed workplace dynamics, with only 50% back to office metrics at this time,” he said. “Chicago downtown office tenants have ‘fled to quality,’ so class A amenitized properties have strong fundamentals but older properties have significant headwinds.” 

Additionally, the Fulton Market District, ranked among the top office construction areas in the U.S., is “accelerating the flight from the conventional CBD. We will see many more office building defaults as decreasing rental income combined with increasing expenses (i.e. property tax) lower owners’ ability to service their debt or refinance into a significantly higher interest rate environment.” 

A phrase that has often been repeated since the onset of the pandemic is that “it’s not 2008 all over again” because banks’ liquidity is greater now compared to 15 years ago. Despite the recent turbulence in the banking sector, Gottlieb believes this remains valid. 

Banks’ soon-to-be-issued first-quarter reports will provide “a snapshot of their financial health. Specifically, I will look to their anticipated losses and reserves they set aside to cover them. I also favor the Texas Ratio analysis to identify which institutions are most at risk of failure.” 

Banks won’t copy their 2008 playbook verbatim when it comes to addressing distressed borrowers or properties, said Gottlieb. “The biggest playbook change I foresee is the avoidance of ‘Extend & Pretend,’” he said. “The robust support and direction by the OCC helped banks cope with COVID’s initial impact, allowing modifications without the usual ensuing ramifications. Banks learned many lessons on how to handle workouts and crashing valuations of CRE during the Great Recession, and I believe banks will take a proactive and pragmatic position when addressing problem properties.” 

He noted that the current decrease in transaction volume makes it “extremely difficult to value properties due to a lack of recent comparative sales.” In the post-2008 period, Gottlieb served as VP and asset manager – real estate disposition at MB Financial Bank, and he recalled that one challenge of that period was that “by the time an appraisal completed its Review and Approval period, the declining market during that time meant that the asset was no longer worth that appraised value.

“If one failed to accept that reality, then one had to wait for the market values to reach bottom and start increasing before the market and appraised values intersected. Some lenders came up with various techniques to adapt to that reality.” 

One difference between 2008 and today is the evolution of a variety of alternative lending sources. Gottlieb saw the evolution of this lending sector as “a huge difference” compared to 15 years ago.  “We have so much more liquidity (for the time being?) in today’s market,” he said. “Many opportunistic funds formed as a result of COVID, and they’re hungry to place. They will provide equity, debt and hybrid alternatives, with the increased competition for deals yielding greater recoveries for the current lenders.”